Reaching highs of around $77 in mid-2011, Abercrombie & Fitch’s (ANF) stock slumped below $30 in mid-2012. The stock fell because ANF could not maintain its growth rate due to three key reasons: weaker than expected U.S. consumer spending, excessive promotions leading to lower average unit retail prices, and weak economic conditions in Europe. However, Abercrombie & Fitch’s stock has climbed since November 2012 as it reported earnings that beat market expectations. We believe that the stock could rise further as the retailer has started addressing its core problems and improving its operations.
First, the company is closing under-performing ANF stores in the U.S. in order to improve overall store economics. Second, it has improved its inventory levels and thus has reduced markdowns. Third, it has slowed down its expansion plans in Europe. With better control over its inventory, the retailer was able showcase its new line of fashion apparel last quarter.  This partly contributed to the company’s outperformance in the quarter.
Consolidation Of Abercrombie & Fitch Stores In The U.S.
Before the recession of 2008-2009, the retailer expanded its ANF stores in lower tier cities (consumers in these cities have lower average disposable income), which yielded unfavorable results. Its premium brand stores were present in the areas where the demographics did not support the pricing. As a result, the overall store economics and productivity were impacted. Furthermore, the economic downturn of 2008-2009 and fewer promotions also worked against the retailer. This explains why the comparable store sales fell down by 13% in 2008 and 23% in 2009. 
However, with the consolidation of under-performing stores and the improvement in the economy, Abercrombie & Fitch stores have started to recover. The retailer reduced the total number of ANF stores from 358 in 2008 to 310 in 2011.  At the same time, the revenue per square feet increased from $440 to $500.
It appears that store consolidation is a prominent trend among retailers in the U.S. Apparel retailers such as American Eagle Outfitters (AEO) and Limited Brands (LTD) are following a similar strategy, and we believe that Abercrombie & Fitch will continue with its consolidation strategy in the U.S. for the next few years.
Better Control Over The Inventory
Over the last year, Abercrombie & Fitch has had difficulty in managing its inventory. This resulted in excessive promotions, which led to decline in the average price per unit. This not only impacted the comparable store sales, but also weighed on the retailer’s margins.  The main reason behind the superfluous inventory was Abercrombie & Fitch’s buying strategy. The retailer’s buying process is focused on anticipating the success of upcoming fashion trends followed by appropriate bulk purchases. Although it predicts the success of these fashion trends through rigorous testing and R&D, there is always an associated risk when fashion is changing rapidly.
Abercrombie & Fitch has answered this problem in the recently concluded quarter. The retailer had a very low inventory turnover in 2011 (ratio of sales to inventory), indicating that the increase in sales was lower than the increase in inventory.  However in Q3 fiscal 2012, Abercrombie increased its inventory at a much slower pace than the sales growth.  Moreover, the retailer started sourcing the goods from within the U.S. and low-cost destinations of Central America, thus reducing the lead time. 
This has helped Abercrombie & Fitch in rolling out new fashion apparel and reducing the number of markdowns. If the retailer is able to maintain similar inventory control in the coming quarters, its sales should continue to improve and thus lead to an increase in its stock price.
Delaying Expansion Plans in Europe
International markets are quite lucrative for Abercrombie & Fitch (contributing around 25% to revenues), but Europe has been particularly weak.  Driven by Europe’s weak economy and self-cannibalization, international comparable store sales decreased by 18% in Q3 fiscal 2012.  It’s hard to believe that with small number of stores in Europe (only 99 international stores as of fiscal 2011), the retailer is facing a self-cannibalization problem. This seems to be due to its over-expansion in tourist locations and local catchments, which resulted in concentration of a number of stores in a particular location. 
However, the company’s management has announced that it will slow down the expansion in the European markets. To expand in the region, under-penetrated markets will be targeted to negate the impact of cannibalization.  Although the weak economic environment in Europe poses a near term threat, the region has good market potential over the long run. Currently, Europe accounts for about 20% of the retailer’s revenues.  The European Commission predicts that economic growth will pick up slightly in 2013, which should help Abercrombie & Fitch’s recovery.  The weakness in Europe has also troubled retailers such as Guess? (GES) and Gap (GPS). 
Strong Direct-To-Consumer Channel
The growth in the U.S. apparel industry is also being driven by direct-to-consumer channel. Retailers such as Urban Outfitters (URBN) and American Eagle Outfitters have thrived from this trend. For Abercrombie & Fitch, this is the fastest growing and the most valuable segment. Direct-to-consumer revenue growth has averaged nearly 35% annually over the last two years. 
Apart from the U.S., this segment has also lifted the results from the international markets. For instance, in Q3 fiscal 2012, the international direct-to-consumer revenues increased by 31% with Europe being the strongest even amid weak economic conditions.  Although this segment only contributes 15% to the retailer’s overall revenues, it can be a valuable driver in the future.
Overall, we believe that Abercrombie & Fitch is leveraging the right aspects for its growth. Store consolidation in the U.S. will improve the retailer’s revenue per square foot. Better control over the inventory will enable it to maintain relatively higher average unit retail. Additionally, slow expansion in Europe will assist the revival of comparable store sales growth. We expect some upside to the stock price on back of these strategies.
Our price estimate for Abercrombie & Fitch Stands at $51, implying a discount of about 10% to the market price.
- Abercrombie & Fitch Q3 fiscal 2012 earnings transcript, Nov 14 2012
- Abercrombie & Fitch’s SEC filings
- Abercrombie & Fitch’s SEC Filings
- Abercrombie & Fitch Q2 fiscal 2012 earnings transcript, Aug 15 2012
- Spring Forecast: towards a slow recovery, European Commission, May 11 2012
- Companies’ SEC filings
Disclosure: No positions.